Bill Black: The DOJ and the SEC Spurn their Ace in the Hole – Richard Bowen

Yves here. This is the second post in a devastating series on why major banks and their executives got away with large-scale, systematic fraud in the runup to the crisis (see the first post here). Bill Black uses Citigroup whistleblower Richard Bowen as a case example of how derelict the DOJ and SEC were in the performance of their duties.

Here, Black describes how historically frauds and criminal conduct were pursued primarily by regulators and the FBI. However, not only were regulations were weakened, but the Bush Administration ended criminal referrals: “References to the criminal referral coordinators disappeared or were removed from the bank examiners’ manuals.” FBI staffing for white collar crime was cut drastically as the war on terror was given precedence.

That meant, as Black describes, whistleblowers became more important than ever as not just a source of information for civil and criminal prosecutions, but as key witnesses. Yet in many cases they are problematic. They are often disaffected former employees who call out the bad conduct they saw after they were terminated, or were so badly roughed up by their former employer for becoming an internal dissident that they were traumatized and don’t hold up well on the stand. Hence, as Black explains, the failure to take advantage of a stellar whistleblower like Richard Bowen. As Bowen put it, “Not only did they bury my testimony, they locked it up.”

By Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Originally published at New Economic Perspectives

In this second column about Richard Bowen, I discuss the failure of the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) to make use of his expertise and testimony.  Bowen was the Citi SVP who blew the whistle on Citi’s senior managers’ strategy of knowingly buying massive amounts of fraudulently originated loans sold to Citi through fraudulent reps and warranties and then reselling those toxic mortgages (primarily to Fannie and Freddie) through false reps and warranties.  My first column described that strategy and the failures of the Financial Crisis Inquiry Commission (FCIC) to understand how damning Bowen and Clayton’s testimony was.  Clayton was the dominant “due diligence” firm for secondary market mortgage sales and was designed to be an easy grader.  The two great epidemics of mortgage origination fraud (appraisal fraud and liar’s loans) were so endemic and so crude that even Clayton found a 46% incidence of false reps and warranties by the sellers to the secondary market who fraudulently originated the loans.  That incidence grew to 54% by the second quarter of 2007.

Bowen led Citi’s 220 person mortgage loan underwriter team.  Bowen’s team initially found in 2006 that the loans Citi was purchasing for resale had a 40-60% incidence of not meeting Citi’s loan standards.  By 2007, despite Bowen’s stark warnings to senior management, that percentage climbed to 80 percent.  The response of Citi’s senior management to Bowen’s repeated written warnings that Citi was engaged in massive fraud was (a) to increase Citi’s purchases of toxic mortgages, (b) to buy far more (endemically fraudulent) liar’s loans, and (c) to retaliate against Bowen and destroy his banking career.  My first column in this series explains why Bowen posed such a threat to the top managers’ fraud scheme that those managers decided their only choice (other than honesty) was to destroy Bowen’s banking career.

Bowen was the perfect witness and expert consultant from the DOJ and the SEC’s perspective to assist in the prosecution of the elite frauds leading Citi and other banks.  He had the key expertise – loan underwriting.  Underwriting and suborning controls are the early “tells” for spotting accounting control fraud by lenders and loan purchasers.  In order to follow the fraud “recipe” the firm’s underwriting and controls must be rendered a sham.  This makes Bowen, as the SVP in charge of a large team of underwriters whose warnings proved so prescient the ideal witness against not simply Citi’s controlling officers, but all other firms’ officers following the fraud recipe.

Bowen was, of course, the ideal witness in a prosecution of Citi’s top leaders for their fraud scheme.  Bowen put them on repeated, written notice of the massive fraud scheme.  Bowen demanded that it stop.  Citi’s top managers instead expanded the scope and the severity of the fraud scheme, achieved an astounding 80% of false or unsupportable reps and warranties by Citi in its sales of toxic mortgages to the secondary market, and retaliated against Bowen for being right and demonstrating integrity.  Bowen was Citi’s controlling officers’ greatest nightmare.

In my first column in this series I demonstrated the need for the FBI and the prosecutors to understand a detailed, technical analysis of the fraud schemes and have experts that could explain the points to a jury in understandable terms.  Bowen was ideal for the first task.  I don’t know how good he would have been in explaining it to a jury, but that is a skill that can be developed through practice.

I have written several columns in which I have explained the indifference and incompetence of the DOJ’s response to the financial whistleblowers.  The first point to make is that because of a different form of incompetence – the Bush (II) administration’s destruction of the criminal referral process at the banking regulatory agencies and the Obama administration’s even more inexplicable refusal to restore an effective criminal referral process the sole means by which the FBI and the DOJ could succeed in prosecuting the elite fraud is through whistleblowers.  (They could also use people like me as experts, but we all know that Holder would prefer to drink a cup full of broken glass rather than accept help from people like me.)

The Essential Need to Restore the Criminal Referral Process

The single most distressing fact about the Obama administration’s refusal to restore an effective criminal referral process at the banking regulatory agencies is that doing so would be the first thing any competent law enforcement professional would do.  Banks do not make criminal referrals against their controlling officers.  The FBI white-collar section is staffing is down (on a good day) to about 2,200 agents and we have over 1,000 industries (not firms – industries) in the U.S.  Three things are obvious from those three facts.

1. The system won’t work – we have far too few FBI agents assigned to white-collar fraud
2. The FBI agents cannot “walk a beat” – they only investigate if there is a criminal referral
3. FBI agents will rarely have expertise in the industry they are investigating

Whistleblowers are episodic, so they inherently cannot deal effectively with the fraud epidemics that drive our worst crises.  Few whistleblowers have access to the “C-Suite” where the worst “control frauds” are led.  Some whistleblowers really are disaffected employees.  Other whistleblowers are psychologically damaged by the retaliation.  Divorce is common and they may become depressed, paranoid, and have substance abuse problems.  They may not have great credibility on the witness stand.

Competent and vigorous government financial regulators are typically superior witnesses compared to whistleblowers.  They are rarely subject to similar damaging psychological pressures.  They have nice titles and expertise in their fields.  They have no personal axe to grind.

In the savings and loan debacle (less than one-hundredth the size of the current crisis) our agency, the Office of Thrift Supervision (OTS) made over 30,000 criminal referrals.  The referrals produced over 1,000 felony convictions in cases designated as “major” by DOJ.  The cases that were prosecuted were hyper-prioritized through the “Top 100” process.  We worked closely with the FBI to prioritize the worst 100 fraud schemes.  That represented slightly over 300 S&Ls and 600 individuals.  They were nearly all prosecuted and despite having the best criminal defense lawyers in the world we achieved a 90% conviction rate.  The ability of the regulators to take the lead in successfully prioritizing cases for prosecution is one of the collateral advantages of superb regulatory criminal referrals.

The largest collateral advantage, however, is even more subtle.  The only reason the Top 100 list was created and DOJ and the FBI made prosecuting the elite S&L frauds a top priority was our criminal referrals.  Reporters love numbers and we eagerly released regularly updated numbers on our criminal referrals.  As the number of referrals soared into the thousands and there were only a small number of prosecutions DOJ came under strong criticism with ever new update on our criminal referrals to prosecute.  It had no capacity to prosecute the number of frauds we were referring and no national system for prioritizing its cases.  Creating the Top 100 list was DOJ’s brilliant response.  Once DOJ began successfully prosecuting the elite frauds it got great praise not only from the regulators, but from the media and the public.  DOJ’s senior leadership and President Bush came to understand that elite frauds drove the S&L debacle.  They assured the public that they would bring the elite criminals that led those frauds personally to account for their crimes.

“Attorney General Richard Thornburgh prefaced a Justice Department report on savings and loan fraud with this promise: ‘The American public can be assured.., that prosecution of white collar crime—‘crime in the suites’–and particularly savings and loan crimes, will remain a top priority of the Department of Justice.’  In a speech to U.S. Attorneys in June 1990 President Bush stated, ‘We will not rest until the cheats and the chiselers and the charlatans [responsible for the S&.L disaster] spend a large chunk of their lives behind the bars of a federal prison.’  The president was unequivocal about his plans for attacking financial institution fraud: ‘We aim for a simple, uncompromising position. Throw the crooks in jail’” (Big Money Crime, Calavita, K, Pontell, H., Tillman R., 1997).

Readers know that President Obama and Attorney General Eric Holder have been unwilling to summon and express even remotely similar moral clarity and have granted the elite bankers who led the three fraud epidemics de facto immunity from prosecution.

Even before we made our criminal referrals we were often greatly aiding the eventual prosecution.  First, we trained our examiners to recognize likely accounting frauds.  Second, we trained them to respond by asking the senior officers, in writing, a series of very difficult questions – and documenting in writing the officers’ response.  Bowen provides an excellent example of the difference.  Bowen put Citi’s senior officers on written notice of Citi’s massive frauds.  That is invaluable to DOJ’s ability to prosecute of those managers.  Our examiners and “supervisory agents” did the same thing, but they also took a second step that Bowen could not take.  They required answers to questions that the senior officers were desperate to avoid answering – and lying to a federal regulator is a felony.  The old saying is correct; it is often the cover up that leads to

Competent regulators aren’t supplicants.  We demanded the immediate end to fraudulent practices.  It is far better to stop a fraud than to seek to sanction it years later.  We (OTS’ West Region) would not have allowed any liar’s loans to be made or purchased by a financial institution that we regulated.  This is not a hypothetical claim.  Liar’s loans began to become material in 1990 in Orange County, California.  They weren’t called liar’s loans in that era, but “low documentation” (low-doc) loans and they were far less likely to cause losses than were liar’s loans during the most recent crisis because the modern loans were loaded with other features that greatly increased the risk of default and the risk of loss upon default.  Nevertheless, our examiners promptly identified these loans as inherently unsafe and unsound and inherently unfair to the borrower.  As a result, beginning in 1991, despite being in the midst of countering the S&L debacle, we broke out a team and drove liar’s loans out of the S&L industry.  The worst of the worst lenders, Long Beach Savings, voluntarily gave up federal deposit insurance and its charter as an S&L, converted to an essentially unregulated mortgage bank, and changed its name to Ameriquest for the sole purpose of escaping our regulatory crack down.  Ameriquest also targeted blacks and Latinos for its predatory loans.  (I recommend reading Michael W. Hudson’s book, The Monster, about Ameriquest.)  As MARI reminded the entire mortgage industry in its 2006 report on fraudulent liar’s loans, those loans in the early 1990s caused material losses.

[M]any members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.

“Hundreds of millions of dollars in losses” from what was only a few billions of dollars in liar’s loans should be ample to send the warning not to make liar’s loans, but it is not remotely sufficient to cause a crisis.  Indeed, our crackdown on liar’s loans that began in 1991 was so prompt and effective that the loans caused no major failures.

OTS criminal referrals went through what we would now call “continuous improvement.”  Every major office had an experienced “criminal referral coordinator” who met with his FBI counterparts at least quarterly to get feedback on our referrals for the purpose of maximizing their usefulness to the FBI.  The coordinator would then train our staffs and work with them in preparing major referrals to incorporate the feedback from the FBI.  A typical major referral would be 30 pages long and have hundreds of pages of attachments of the key excerpts from the vital documents, complete with useful tabs and cross-references to ease the reader’s access to the most important information.  The referral was the roadmap to a successful investigation and prosecution.  It explained and documented the fraud scheme, the perpetrators, the most important documents and excerpts, witnesses, key supervisory correspondence, and testimony taken under oath in our enforcement actions.

The criminal referral process only begins the transfer of expertise from the regulators to the FBI and the prosecutors.  For the most important and complex cases we would “detail” an experienced examiner who was part of the team that examined the S&L to the FBI.  The examiner would serve as the FBI’s internal expert.  Given grand jury secrecy (6 (e)) this is particularly valuable because the FBI and AUSA can rarely share either documents or testimony obtained through the grand jury process with the regulators.  An examiner who is “detailed” to the FBI and no longer receives his instructions from the regulators can be sworn as an agent of the grand jury and continue to provide expertise to the FBI and the prosecutors.

Our examiners and supervisors often served as fact witnesses in the trial.  They were able to share with the jury the tough questions they asked the senior managers and the responses they received.

The regulators played an important role in training the FBI and the prosecutors about the industry and its fraud schemes to aid their ability to investigate and prosecute elite frauds by the controlling officers.  At peak, 1,000 FBI agents were assigned to the S&L investigations.  The federal S&L regulators (and we sometimes received critical support from state regulators) had roughly 1300 professionals available to assist the FBI and the prosecutors.  Each of those 1300 regulatory professionals, of course, had greater industry expertise than any FBI agent or prosecutor.  The combined expertise of the regulators, FBI agents (and IRS and Secret Service agents and accountants), and prosecutors produced the greatest success in prosecuting elite white-collar criminals in history.

At peak, in response to the vastly larger and more destructive fraud epidemics that drove the recent crisis there were roughly 250 FBI agents assigned to all cases of mortgage fraud nationwide.  The vast bulk of them were assigned at all times to cases in which the FBI in essence served as a collection agency for the most fraudulent lenders.  The result has been the greatest strategic failure in prosecuting elite white-collar criminals in DOJ’s modern history.

Under Bush (II) and Obama, however, DOJ has refused to prosecute any senior bank officer who helped lead the three most destructive financial fraud epidemics in history.  Most Americans assume that only the elite bankers that led the three fraud epidemics have received this de facto immunity from criminal prosecution, but that immunity has extended to senior bankers at even bankrupt and notoriously fraudulent mortgage banks and junior officers at the large banks.  The Bush administration brought an inept prosecution of two relatively junior Bear Stearns hedge fund officers that failed in 2009.  There have been no prosecutions of even junior officers of the large banks who took even modest leadership roles in the three fraud epidemics in the following six years.   The three fraud epidemics caused our financial crisis and Great Recession which is estimated to cause the U.S. a $24 trillion loss of GDP and over 10 million jobs.  (Both numbers are far larger in Europe.)

The Death of Criminal Referrals

The criminal referral process at the banking regulatory agencies was effectively ended, without any public notice or rationale, by the second President Bush.  References to the criminal referral coordinators disappeared or were removed from the bank examiners’ manuals.  The result was that OTS and the Office of the Comptroller of the Currency (OCC) admitted that they made zero criminal referrals in response to the most recent crisis.  FCIC says that the Fed made three referrals for discriminatory lending.  The FDIC was smart enough to refuse to answer the question.  Despite recurrent criticism the Obama administration has never announced that it has ordered the creation of an effective criminal referral process at the banking regulatory agencies.  The Obama administration cannot claim that it is vigorously pursuing the frauds when it refuses to do the simplest, fundamental things that we know how to do and know are essential to successful prosecutions.  The Obama administration does not need to reinvent the wheel.  We know exactly how to create a superb criminal referral system at the banking regulatory agencies.  Any administration that wished to enforce the law against elite bank frauds would have made this there first action.

Whistleblowers are DOJ’s Only Means to Prosecute

The Obama administration’s failure to reestablish and effective criminal referral process and to appoint regulatory and prosecutorial leaders who will make the prosecution of elite bank fraudsters a top priority leaves DOJ with only one avenue of successful prosecutions of those elite banksters – whistleblowers.  (Again, Holder would far rather fail than accept the repeated offers of help of those of us with a track record of success.)  This makes Bowen a vastly more important asset to the DOJ and the SEC today than he would have been during the S&L debacle.  He and few whistleblower peers are the DOJ’s and the SEC’s only “ace in the hole.”  Holder, however, constantly folds rather than playing his sole ace in a criminal prosecution of the elite banksters.  Of course, the pretense that Holder or Obama actually want to bring successful prosecutions against the elite banksters doesn’t fool anyone at this juncture.

Given the death of criminal referrals by the regulatory agencies, if Holder were serious about enforcing the rule of law against the elite bankers who led the three fraud epidemics he would make every effort to recruit whistleblower like Bowen.  He would constantly be asking for them to come forward and vigorously seek leads on potential whistleblowers that the FBI could personally approach and ask for their help.

Virtually every major DOJ case against the largest banks was made possible by whistleblowers, including the cases against Citi, JPM, Bank of America, HSBC, Credit Suisse, and Standard Chartered.  DOJ refuses to prosecute the elite bankers who led the three fraud epidemics even when it brings actions made possible by the whistleblowers’ revelations.  Holder loves to attend the press conferences announcing these settlements and non-prosecutions (oxymoronically referred to as “deferred” prosecutions).  The press conferences provide the ideal opportunity for Holder to praise the whistleblowers, ask for new whistleblowers to step forward, promise the whistleblowers that their information, if credible, will lead to prosecutions of the elite banksters, and explain how whistleblowers should contact DOJ.  Holder and his subordinates have done this in zero cases.  They fail even to mention the whistleblowers.  Again, if Holder actually wanted to prosecute the banksters we know he would never act in the manner he consistently does when it comes to whistleblowers.

The problem, of course, is not limited to Holder and the non-prosecutors he selects to not prosecute the banksters but instead get useless fines assessed solely against the bank rather than the officers looting the bank.  As I have been urging for years, the most obvious thing we could do to in the whistleblower context to aid prosecutions of the elite banksters would be for President Obama to award the whistleblowers medals in a televised Rose Garden Ceremony in which he thanked them for their service, called on whistleblowers to come forward, and explained how they should contact DOJ.  The President should also have the whistleblowers attend the State of the Union Address as Mrs. Obama’s guests.  His SOTU address, of course, would praise their actions and the TV cameras would show them to the world.  This would be great public policy and great politics for the President and his Party.  When a president refuses to take actions that are substantively desirable and politically brilliant he is either terminally inept or in the pocket of the elites that the whistleblowers are unmasking as venal frauds.

Holder and the SEC’s Refusal to Harness Bowen’s Expertise

I am simply using Bowen as a prominent example of DOJ’s refusal to harness the expertise of the whistleblowers.  The three most prominent whistleblowers who made possible the civil fraud cases against Citi (Bowen), JPM (Alayne Fleischmann), and Bank of America (Edward O’Donnell) were exceptionally good witnesses for the prosecution.  They were not disaffected employees.  They were trying to protect their banks from harm and to cause them to act with integrity and professionalism.  They did not wait until after a disaster to protest – they risked their careers by warning in advance of the disaster and their warnings proved correct because of their great expertise.  They were the victims of retaliation for the unforgivable crime of trying to do the right thing when their bosses stood to be enriched by looting the bank by inducing employees to do the wrong thing.  I explained earlier why competent, vigorous regulatory witnesses are typically less vulnerable to effective cross-examination than whistleblowers.  In these three cases, however, the whistleblowers are so stellar that they would be exceptions to that rule even if the regulators were competent and vigorous.  The regulators were neither during this crisis.

The most obvious way in which these whistleblowers could aid the DOJ and the SEC is as fact witnesses about the actions of their bosses and their reactions to the whistleblower’s warnings.  However, given the death of criminal referrals, the exceptionally pathetic quality of the regulatory leadership, and Timothy Geithner’s open hostility to prosecuting the banksters’ who interests he had so assiduously promoted in his role as a faux regulator at the NY Fed and his continuing destructive role as he gradually became President Obama’s principal financial advisor, the FBI, SEC, and DOJ receive virtually no expertise from the regulators as to the industry or its fraud schemes.  In these tragic circumstances Bowen, in particular, is invaluable as a consultant to the FBI, SEC, and the DOJ.  They should be in at least weekly contact with him about dozens of cases.

Again, underwriting and controls are the “tells” because they must be suborned and perverted so extensively that the bank officers will make and/or purchase tens of thousands of loans it knows to be fraudulent.  I have explained how establishing this fact allows effective prosecutions of the bank’s senior officers.  Bowen is therefore perfectly positioned because he was a vital internal control in charge of underwriting.  He also knows how loan origination and secondary market sales work.  He should be serving as DOJ’s lead expert witness in scores of prosecutions of elite bankers.

In his recent Bloomberg interview, however, Bowen revealed that DOJ has not communicated with him in over 18 months.  A September 21, 2013 article in the New York Times by William Cohan contains an equally depressing revelation.

Then, in July [2008], Mr. Bowen went to the Securities and Exchange Commission. “I testified before the S.E.C.,” he told an audience in Texas earlier this year. “I told them what had happened.” He gave the S.E.C. more than 1,000 pages of documents. “Mr. Bowen, we are going to pursue this,” the agency told him. He never heard back. “Not only did they bury my testimony, they locked it up,” he said in his speech. (The S.E.C. has denied my numerous requests under the Freedom of Information Act for access to Mr. Bowen’s file, even though he has given his permission, claiming that the material was ‘confidential’ and included Citigroup ‘trade secrets.’ On Sept. 11, the S.E.C. denied my administrative appeal of its decision.)”

Yes, we wouldn’t want Citi’s fraudulent “trade secrets” to slip out lest they prompt the ghost of Charles Keating to sue Citi for infringing the fraud “recipe” he made infamous 30 years ago.

As always, the message is that the DOJ and the SEC refuse to take the most obvious, foundational actions essential to success that any professional would take if he or she sought to restore the rule of law and end Wall Street, the City of London, and Switzerland’s corrupt financial cultures.  The Obama administration’s “revealed preferences” are obvious.

And, yes, Bush (II) was even worse.  Bowen went to the SEC when Bush’s appointees ran it.  But there is something particularly disgusting about Holder’s hypocrisy, at the very moment he was ignoring Bowen, in going to the Wall Street Journal and claiming:  “The Obama administration is scouring Wall Street for whistleblowers….”  Lies, damn lies, and Holder.